Regional President Speech

r Statement of Frank E. Morris President of the Federal Reserve Bank of Boston before the House Committee on Banking, Finance and Urban Affairs Washington, D.C. July 31, 1978 I appreciate the opportunity to testify on an issue which has great long-run consequences for the efficient conduct of monetary policy and the stability of our banking system. I propose to limit my remarks to two principal areas: (1) the Federal Reserve System's membership problem, how it has come about, why it is a problem and what can be done about it, and (2) the issue of charging for Federal Reserve services--why it will be publicly beneficial once the member ship burden has been eliminated. Membership Burden While membership in the Federal Reserve System entitles banks to receive free services provided by the System, member banks are required to hold reserves against demand and savings and time deposits either as vault cash or as deposits with Federal Reserve Banks. Non-member banks are permitted by state authorities to hold most of their reserves as earning assets or in the form of balances which the normal course of business would require. Historically, the Federal Reserve has not paid interest on reserves held by member banks, so that membership involves a cost equal to the interest foregone on the non-earning balances held at the Federal Reserve. The difference between the value of the services received and the interest foregone equals the net burden of membership. If the member bank gives up more in interest revenue than the value of services it receives, then it may be to the member bank's advantage to withdraw from the System and purchase these services from a - 2 - correspondent. Over the past ten years the net burden of membership has increased sharply as a consequence of the inflation-connected rise in open market interest rates. For all member banks it is esti mated that the net burden of membership is about 9 percent of 1977 before-tax income. For banks in the $100 million to $1 billion deposit size class, where the most serious erosion of membership has occurred in recent years, the net burden is estimated at 10 to 12 percent of pre-tax earnings. The net burden associated with membership 1n the Federal Reserve System is in effect a Federal franchise tax which member banks must pay but which non-member banks can avoid. Since the Federal Reserve System is the only central bank with voluntary membership, banks can avoid this Federal franchise tax by relinquishing their membership. When Congress passed the Federal Reserve Act it neither foresaw nor intended that Federal Reserve membership would involve a substantial financial burden. The goal of the present legislative package should be to adjust benefits and costs so that the Federal Reserve membership decision will not involve either a net burden or a windfall gain. Decline in Membership During 1977 11 banks in New England and 58 banks in th rest of the U.S. withdrew from the Federal Reserve System. Thee 11 banks accounted for about S percent of th total number of member banks in New England and had deposits of more than 10 percent of total deposits held at all member banks. By the end of 1977 the proportion of insured commercial bank deposits held by commercial -3- banks in New England had fallen below 63 percent in New England and 75 percent elsewhere, which compares with figures of 77 percent and 79 percent, respectively, at the end of 1972. In the past, the membership problem has been largely restricted to small banks; but this is no longer the case. During 1977, 8 of the 11 banks which left the System in New England and 7 of the 58 banks which withdrew in the rest of the United States had deposits of $100 million or more. Among them, these 15 banks had total deposits of $3.3 billion. We have discussed the burden of membership in an open and frank manner with our members in New England and attempted to impress upon them that the System intended to seek Congressional action to alleviate the net burden. As a result of these discussions many banks have temporarily postponed their decision pending the outcome of legislation. Thus far in 1978, only three New England banks have announced target dates for withdrawal. However, an additional 34 banks have indicated that they are seriously considering withdrawal from membership. Of these 34 banks, 14 have deposits of $100 million to $500 million, and three have deposits of over $500 million. Together the 37 banks have deposits of $5.3 billion and account for almost 28 percent of deposits held by all member banks in New England. These banks currently keep $273 million in reserves with the Federal Reserve Bank of Boston upon which we earned (and turned over to the Treasury) almost $18 million in 1977. If no action is taken, it is probable that by the end of 1979 Federal Reserve member banks will hold less than half of all commercial bank deposits in New England. -4- The rate of withdrawal by member banks is substantially greater in New England than elsewhere, although the trend is accel erating around the country. The higher rate of withdrawal by member banks in New England is due to several factors. First, hecause of aggressive competition from well-established thrift institutions, commercial banks in New England have difficulty in attracting time and savings deposits and as a result tend to have higher ratios of demand deposits to to~al deposits than do banks in the rest of the country. Because the impact of reserve requirements falls mainly on demand deposits, the net burden of membership is relatively larger for New England banks of a given size than for equivalent banks elsewhere. A second factor responsible for the greater exodus in New England is the impact of NOW accounts and the related fact that thrift institutions, unlike their counterparts 1n most other sections of the country, can offer full service banking to the consumer. The intensified retail banking competition has resulted in lower profit margins for New England bankers. For example, in 1977, net income before taxes and securities transactions as a oercentaQe of total assets was 0.76 percent in Massachusetts. The corresponding figure for commercial banks nationally in 1977 was 1.09 percent--more than 43 percent greater. This relatively weak earnings performance has generated pressure to increase earnings by leaving th Federal Reserve and avoiding the Federal banking franchise "tax." All of the New England banks that have left the System have done so - 5 - reluctantly, but the pressure of the "bottom line" has been just too great. Why Declining Membership is a Problem The erosion of membership worries me, because the System's very reasons for existence are being threatened. The membership problem impairs the ability of the Federal Reserve to conduct monetary policy with the precision we are seeking. Every time a bank leaves the System our information base on deposits shrinks, the reserve base shrinks relative to the deposit base and the reserve multiplier (the relationship between a change in reserves and a change in deposits) will become more unstable. In an era when precise control of the money supply is given more importance than ever before, the membership problem is weakening the ability of the Federal Reserve to execute monetary policy. In addition, the banking system is rendered more vulnerable and the ability of the economy to withstand financial shocks is lessened by the fact that an increasing proportion of banks do not have access to the discount window. In recent years the development of sophisticated techniques of liability management have lessened the importance of the discount window as a routine source of liquid.ty, and many banks leaving the System believe that if need should arise they will be able to obtain liquid fund from their large correspon dents. In the normal course of events, there is no doubt that the large banks will be able to meet the liquidity needs of their smaller correspondents. But if a general liquidity crisis should occur, the -6- large banks may not be able or willing to meet the needs of all non-member banks. Even if thev h8VP thP f11nds available or are able to obtain them from the Federal Reserve, the large banks may be reluctant to assume the substantial credit risks involved in numerous large scale advances to their correspondents. It should be remembered that the original impetus to the formation of the Federal Reserve was the failure of the correspondent network to provide adequate liquidity to country banks during the financial crises of the early 1900s. The Federal Reserve is the only lender that can unconditionally guarantee a sufficient supply of funds in times of crisis, but performance of this guarantee requires a direct relationship between the Federal Reserve and the borrowing bank. The decline in membership thus endangers the performance of a Federal Reserve function which is only of routine importance presently but whose successful implementation in time of crisis is imperative. Two Solutions There are fundamentally two ways of dealing with the problem. One way is to mandate uniform reserve requirements, placing all financial institutions on an equal footing. If the Congress remains unwilling to do this, then it should approve the only alternative solution--to eliminate the excessive burden of membership in the Federal Reserve. The proposal made by the Board of Governors to reduce the membership burden by a combination of reserve requirement reductions and interest payments on reserve balances will solve the problem at little or no cost to the Treasury in the long run. - 7 - In my judgment the Board's cost estimates are much too high, since they make no allowance for the effect of increased membership. There is no doubt in my mind that if the Board's program were adopted, most of the New England banks which left the System would rejoin promptly, along with many commercial banks and some savings banks which have never been members. In the long run, I believe that the cost of the Board's program to the Treasury will be less than the cost to the Treasury of doing nothing and suffering the declining revenues produced by a continued decline in membership. Service Charges I would like to turn now to the issue of the pricing of Federal Reserve services. It is an economic truism that any costly service provided free of charge will be overused. Resources are wasted because the cost of providing the service will inevitably be higher than its value to the marginal user. It is unfortunate that the Federal Reserve must offer free services to member hanks to partially offset the cost of the non-earning balances they must keep with us as reserves. Both the Federal Reserve and the commercial banking system would operate more efficiently if they paid depositors a market rate of interest on their deposits and charged for services on the basis of the costs incurred in providing those services. In any industry in which price competition is constrained, competition takes the wasteful form of giving away frees rvices- and the more competitive the industry th more waste is generated. -8- We saw this in the brokerage industry before fixed pricing was abolished. We see it now in the commercial banking industry where the more competitive the market, the more institutions compete by offering free services or other amenities which cost more than their value to the consumer. The free checking account is one common example, the proliferation of expensive branches another. For example, New England commercial banks have attempted to compete with one another by increasing the number of banking offices to offer greater convenience to the customer. As a result, total deposits at commercial banks in New England were only about $13.3 million per office at the end of 1977 compared to $20.6 million per office in the rest of the country. The effect of these lower deposits per office is to increase substantially operating costs per dollar of deposits. In 1977 the non-interest expense per dollar of assets at New England commercial banks was almost 26 percent higher than for banks in the rest of the country. Ultimately, these higher costs must be borne by the consumer. When banks are charged for Federal Reserve services, they will use those services more sparingly. In some cases they may do more processing of the checks themselves or they may set up more local clearing associations in which they can simply swap checks among themselves, avoiding the Federal Reserve System altogether. To the extent that such services can be performed outside the System at a lower cost, this private market development would simultaneously save money for the public and reduce the heavy check burden which the Federal Reserve now bears. Thus, the introduction of pricing would improve the efficiency of the nation's payment system. - 9 - Pricing will also increase efficiency by reducing the use of checks as a means of payment. From 1972 to 1977 the number of private checks processed by the Federal Reserve System increased from 8.4 billion to 13.3 billion or by 58 percent. This rapid growth in the use of checks has imposed substantial costs on both the commercial banks and the Federal Reserve System. If depositors were charged for each check written, future growth in the volume of checks would be substantially reduced (especially in checks for very small amounts), with significant savings for both the commercial banks and the Federal Reserve System. Pricing will also hasten the rate at which substitutes for checks are introduced. At present, the public shows no great enthusiasm for innovations such as electronic funds transfer systems, since the present system of paper checks is provided at no charge. However, if customers were charged the costs of check processing, the relative costs and convenience of EFTS would become more attrac- tive. Pricing would also eliminate another deficiency in the structure of the Federal Reserve System. As matters now stand any bank which requires few System services pays the same membership fee in terms of lost earnings on reserves as does a bank of the same size which uses many System services. Thus, a large member bank with a small correspondent business now carrie a much larger net burden than does a member bank of the same size with a large correspondent business. If the System membership package could be unbundled so that member banks were required to pay for all -10- the services they receive, we would create a much more equitable and logical system. Unfortunately, the System cannot introduce pricing for its services until the burden of membership is eliminated. The membership problem not only creates obstacles for the efficient conduct of monetary policy but it is blocking the way toward a more efficient and less costly banking system for the American public.

Frank E. Morris (1978, July 30). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19780731_frank_e_morris

@misc{wtfs_regional_speeche_19780731_frank_e_morris,
  author = {Frank E. Morris},
  title = {Regional President Speech},
  year = {1978},
  month = {Jul},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19780731_frank_e_morris},
  note = {Retrieved via When the Fed Speaks corpus}
}